As we have reported in the past, the ethanol industry is undergoing some extended hardships and ethanol players' margins will be squeezed as the sector works through these trying times. Since summer, we have seen oversupply plague the industry and the price of corn continues to rise. If ethanol was indeed going to replace gasoline and be the fuel of the future, changes needed to happen first.
This morning, the first incarnation of these changes appears to have happened, as VeraSun Energy (VSE) announced its acquisition of US BioEnergy (USBE) in an all-stock deal. Under the deal, 0.81 shares of VSE stock will be issued for each outstanding share of USBE common stock, representing an approximate 11% premium based on November 23 closing prices. This agreement represents the first merger of publicly traded ethanol pure plays and I am confident it will not be the last. I believe this merger will be the first of quite a few more to follow as the industry continues to unfold.
During the ensuing conference call, management stressed how the merger will create synergies that could not have happened before, namely in the form of higher production yields and a reduction in operating costs. Ethanol profit margins plummeted from $2.30 per gallon last year to less than $0.25 per gallon currently. The combined company should be able to mitigate these kinds of pressures, but what does this mean for the long-term outlook?
Unfortunately, the challenges that the industry faces as a whole are still present. First of all, the "food vs. fuel" issue is still prevalent, where all the corn that is going into ethanol production is depriving consumers of food. Corn prices are going up, and will continue to do so until ethanol is commercially produced from cellulosic biomass. That milestone is at least two years away. Additionally, with no distribution infrastructure to pipe the E85 blend of ethanol to the retailer, we will soon reach the maximum amount of ethanol that the current system can withstand. With approximately 140 billion gallons of gasoline consumed in the U.S. each year, our current E10 formula calls for 14 billion gallons of ethanol to be blended in. The current construction pipeline for ethanol plants will take us to that number in 2009. With CAFE standards potentially raised in the near future, we may already have more ethanol coming online than we need.
This merger may help the two involved players withstand the present market pressure that is being served, but it is overall just a reactive measure to help maintain the status quo. With the aforementioned industry-wide roadblocks still hovering, I fail to see how the combined company will have long-term benefits competitors lack. The customer base (mainly petroleum blenders such as ConocoPhillips (COP) and Marathon Oil (MRO)) has not been diversified either. The combined company will have 1.64 billion gallons of capacity from 16 different plants by the end of next year, making it the largest in the U.S., but hardly making it a better play than the rest.
Given the fragmented nature of the biofuels sector, I would expect more mergers to follow in order for the industry to keep moving forward. I cannot speculate on who will be the next target, though investors with a short position on an ethanol stock may be jolted by a share price spike following the next merger announcement. Also, I would suspect that the 11% premium in this particular deal will slowly come down as company valuations remain depressed.
As surprising as it may sound, I am a strong believer in alternative fuels. I always have been. I believe that ethanol has a bright future as we strive to reduce our dependence on petroleum. But we have a ways to go before this mission can be accomplished.
Where to start? A comprehensive energy bill that directly addresses the industry's challenges would be a great place to start. Of course, such a bill would need to pass first…
Disclosure: I own none of the stocks mentioned above. I do not (yet) drive a flex-fuel vehicle.
Photo:sroemerman, Creative Commons, Flickr